2019 has seen more activity by not-for-profit Boards than in past years. Increased concerns regarding the apparent high level of executive total compensation relative to the mission of the not-for-profit, as well as greater publication of not-for-profit executive compensation levels, have put pressure on Boards and their compensation committees. As a result, Boards must take a closer look at how they are compensating their executives. Let’s take a closer look at the issues surrounding not-for-profit executive compensation, as well as some alternatives Astron’s clients are entertaining for 2020.
What Drives Nonprofit Executive Compensation?
Research provided by Nonprofit Quarterly highlighted the following conclusions:
- While pay-for-performance is a factor in determining compensation, it is not prominent. In fact, in all the subsectors studied, CEO compensation is more sensitive to organizational size and free cash flows than to performance.
- The IRS intermediate sanction regulations have been used to penalize nonprofits that excessively compensate executives. These regulations determine the reasonableness of executive compensation based on benchmarking against comparable organizations. Nonprofit Quarterly’s research, however, suggests that strong industry-specific similarities in pay are related to free cash flows and, to a lesser extent, organizational size, rather than to performance. Hence, the existing regulations may not be particularly effective in identifying absolute levels of compensation that are too high.
- One final analysis implication bears on the enduring performance measurement quandary that confronts so many nonprofit organizations. Nonprofits may rely on organizational size to make compensation decisions, drawing on free cash flows when available, rather than addressing the challenge of defining, quantifying, and measuring the social benefits that they produce.
- Nonprofits typically produce services that are complex and that generate not only direct outputs but also indirect, long-term, and societal benefits. These types of services often make it difficult to develop good outcome measures and to establish causality between program activity and impact. In the absence of effective metrics of social performance and mission accomplishment, many organizations rely on other factors in setting compensation.
- Perhaps, once better measures of mission fulfillment are developed and actively implemented, nonprofits will be able to structure CEO compensation in ways that provide appropriate incentives to managers who successfully advance the missions of nonprofit organizations.
The issue of compensating executives more on outcome-based measures of performance rather than specific services / revenue size industry comparisons is beginning to change. Recently, several Astron Solutions clients have requested further analysis of 990 data, in order to correlate additional organization metrics, such as margin per FTE, customer satisfaction scores, and growth in services, to base salary and total compensation actually paid. We predict that this trend will continue to grow in 2020.
What About Retirement?
A second area that has become a priority for many not-for-profit Boards is increased review and implementation of deferred compensation arrangements for executives. The following is a summary provided by Gregory J. Leone, AIF®, CIMA®, CPFA, Director, Retirement Plan Services for Georgetown Financial Group.
- There is a key question on the minds of nonprofit and tax-exempt organizations. It is the same question facing all successful businesses: How do we keep our most talented people from leaving to work elsewhere?
- Just like their for-profit counterparts, nonprofit organizations are seeking ways to recruit, reward, and retain key executives. But the challenge to keep executives is even greater for nonprofit organizations. Like for-profit businesses, nonprofit and tax-exempt organizations are limited as to the types of benefits they can offer key executives. Qualified retirement plans, such as 401(k), profit sharing, and 457(b) plans, have contribution limits. Nonqualified benefits must meet the requirements of ERISA and § 409A.
- But unlike ordinary corporations, benefits offered by nonprofits must, with some exceptions, also meet the restrictions of IRC § 457. For deferral plans that want to exceed the § 457(b) contribution limits, nonqualified benefits for executives and directors must be subjected to “a substantial risk of forfeiture.”
- Fortunately, there are compensation alternatives which can help nonprofit and tax-exempt organizations retain their most-valued executives and directors. Depending on the needs of the executive or director involved, nonprofit organizations should consider the following five plan designs for offering nonqualified benefits:
- § 457(f) Plans,
- Split-Dollar Loans,
- Split-Dollar Loan / § 457(f) Combo arrangements,
- Executive Bonus plans, and
- Restricted Executive Bonus Arrangements (“REBAs”).
Factors to Consider
- The key to selecting a retirement benefit is to determine which of the following factors are most important to the organization and the executive: (i) tax deferral for the executive, (ii) avoiding a “substantial risk of forfeiture”, (iii) flexibility, (iv) “golden handcuffs”, or (v) providing cost recovery to the organization.
- Tax Deferral: Sometimes the primary reason for implementing a nonqualified plan is to allow executives to defer taxation on income until the money is needed (i.e., not pay taxes on a benefit until retirement). For executives of nonprofit and tax-exempt organizations, benefits which offer tax deferral must generally comply with IRC § 457.
- Avoiding “Substantial Risk of Forfeiture”: The price for unlimited contributions and tax deferral when working for a nonprofit or tax-exempt organization is that the benefit must be subject to a “substantial risk of forfeiture.” Many executives and directors may prefer to seek a benefit arrangement which avoids this requirement.
- According to § 457(f)(3)(B), a benefit is “subject to a substantial risk of forfeiture if such person’s rights to such compensation are conditioned upon the future performance of substantial services by any individual.” In practical terms this means that tax deferral is available to executives and directors of nonprofit organizations only where the benefit does not vest until it is paid out and the benefit is likely to be paid out in a lump sum.
- Flexibility: As was indicated above, for all practical purposes, benefits which allow executives of nonprofits to defer taxation will be paid out in a lump sum. This is because such benefits will be fully taxable under § 457(f) as soon as there is no longer a substantial risk of forfeiture. Thus, once a benefit has vested, the IRS will require the executive to recognize the full amount of the benefit as ordinary income even if the benefit is scheduled to be paid out over a period of years.
- Executives and directors who want to be able to take payments in forms other than a lump sum, or who want the ability to change the schedule of payments, will seek a plan design that is not to the restrictions of § 457(f).
- “Golden Handcuffs”: One of the primary reasons for employers to implement nonqualified plans is to provide incentives that will help retain key executives. Where a benefit is tied directly to a requirement that the executive continue working for the employer, the arrangement is said to have “Golden Handcuffs.”
- Cost Recovery: Sometimes a nonprofit or tax-exempt organization will not be interested in offering a benefit to key executives unless it can recover some or all the costs of providing benefits.
- Plan Types
- Depending on which of these factors is most important to the organization and executive involved, you may want to consider one of the five designs noted above.
The issue of “deferred compensation” for not-for-profit executives has grown in importance during 2019, and will continue to grow into 2020 and beyond. Many not-for-profit executives are 50 – 60 years old. As such, they seek creative ways to defer their compensation for retirement. Not-for-profit organizations can take advantage of this by linking these deferred arrangements to both performance outcomes as well as creating “golden handcuffs” to incent the executive to stay with the organization.
Thank you for joining us for our Astronology® 2020 compensation predictions series! We look forward to your thoughts not only on this issue’s topic – Not-for-profit Executive Compensation – but also on anything in this three part series! Please share your comments in the feedback section below.